Buying life insurance ensures that one or more people or institutions you name as beneficiaries of the insurance policy will receive a lump sum payment upon your death. Having life insurance ensures that your named beneficiaries receive tax-free money that may be applied to their own needs or to your estate’s final expenses, debt, or taxes.
California is one of 38 states that does not have an inheritance or estate tax. However, there are other taxes that may apply to assets held by an estate.
To provide cash to pay the estate’s debts and expenses, you could create an irrevocable life insurance trust (ILIT), which names the trust as beneficiary of the insurance policy. This separates the insurance policy payout, which is typically more than $150,000, from the estate, so the taxable value of the estate does not increase. The bylaws of the trust could say that money in the ILIT is to be used to settle your estate’s debts or to make whatever payment you choose. This protects heirs from being forced to sell real estate, stocks, or other assets to raise cash needed for debt the ILIT will cover.
Because life insurance does not pay until you die, a current, paid-up life insurance policy is not considered a part of your estate. It is the insurance company’s money, which by contract, they pay to your named beneficiaries. The money is never yours. This holds true unless the policy is written as payable to your estate or the beneficiary of the life insurance policy has died. In that case, the money becomes part of your estate. In California, if your life insurance is not current, it will be included in your estate. That means it will go through probate and be used to pay off debts before any money left over is paid to your beneficiaries.
Understanding Life Insurance and Estate Planning
Establishing life insurance is part of the process of estate planning. Estate planning is necessary to document how you want your property and assets to be distributed when you die. Having a current life insurance policy provides money to the beneficiaries you name, typically people who have been financially dependent on you during your adult life.
Life insurance is particularly useful to those you leave behind because it typically pays within weeks and provides a substantial sum of money while your other assets go through probate. The probate process can last a year or more, leaving assets held by your estate unavailable to your family members.
If your life insurance is in a trust, the money it provides also bypasses probate. Assets in a trust are legally owned by the trust, not an individual, so they do not go through probate. The bylaws of the trust will designate how trust assets are distributed. Your named trustees are legally bound to act as the bylaws dictate.
For example, you may set up an irrevocable life insurance trust for the benefit of your child, which is funded by assets of your insurance policy and payable to the beneficiary upon their 21st birthday. You could name your spouse and brother as co-trustees. If you died before your child turned 21, bylaws would require the trustees to invest the insurance payout during the intervening years. It is hoped that returns on the investment would increase the value of the trust’s assets and your child’s eventual inheritance.
If your child is 21 or older, when you die, the insurance payout would transfer seamlessly to the trust and then to your child.
This is properly done with an irrevocable life insurance trust. An ILIT:
- Cannot be changed, altered, or revoked
- Bypasses probate
- Is shielded from creditors.
A revocable trust:
- Can be changed, altered, or revoked
- Bypasses probate
- Is not shielded from creditors.
Because a revocable trust can be changed, the assets of the trust are considered part of the trust creator’s estate. Therefore, its assets may be seized to pay the estate’s debts before what is left is distributed to trust beneficiaries.
The Impact of Life Insurance on Estate Tax
California does not have an estate tax, but the federal estate tax may apply to some large estates. The federal estate tax exemption is increased every year. For 2024, it is $13,610,000. If your estate is worth more than $13.6 million, or the threshold in place when you die, your estate could be subject to federal tax.
If you transfer title and control of your life insurance policy to someone else, such as an ILIT, it will not count toward your estate after you die. You may also transfer ownership to another person who takes up premium payments, such as an adult child. The insurance company can help you do this. However, there are requirements, including:
- The Three-Year Rule. Under this IRS rule, the transfer must take place within three years before the original policyholder’s death and be made without any consideration, meaning without the policyholder receiving anything of value in return.
- Not Retaining Incidents of Ownership. If you keep any incidents of ownership over the policy despite a transfer, the IRS will count the policy as part of your estate for tax purposes. Incidents of ownership include the authority to:
o Cancel, surrender, or convert the policy
o Use the policy as collateral to borrow money
o Change the named beneficiary on the policy
o Select the method of payment for the policy (i.e., installments or a lump sum).
- Gift Taxes. When you transfer property from one person to another without consideration or with consideration that is less than full value, the transfer may be subject to the federal gift tax. Because the gift tax exclusion is so low ($18,000 per donee in 2024), many life insurance policies transferred as gifts will be taxed upon payout.
If you do not transfer ownership of a life insurance policy and your estate is subject to the federal inheritance tax, your heirs could use the life insurance proceeds to cover potential estate taxes, thereby protecting the value of the estate.
Immediate Estate Creation Through Life Insurance
For smaller estates, the decedent’s life insurance is often one of the major assets left to heirs. The payout from a life insurance policy can provide one or more beneficiaries with immediate financial support.
Depending on your desires or your family’s needs, you may name multiple beneficiaries to a life insurance policy, as well as primary and contingent beneficiaries. Primary beneficiaries are first in line to receive the payout, and contingent beneficiaries are paid if the primary beneficiaries are no longer alive or can’t be located.
It is important to keep life insurance policies current. It is advantageous to name primary and contingent beneficiaries. If there is no living beneficiary of your life insurance policy, the payout becomes part of your estate and will be distributed to heirs named in your will. If you do not have a will, your assets will be distributed to family members according to California’s rules for intestate succession.
Inclusion of Life Insurance Policies in an Estate Plan
Life insurance is an integral part of most families’ estate planning because of the amount of money a policy provides upon death and the immediacy of payment. There are two major types of life insurance:
- Whole or universal life insurance. Whole life plans combine a savings plan along with insurance protection. In addition to the death benefit, the investment value of the plan increases as premiums are paid. The policyholder can borrow against the value of the plan or cash it out for its full value (minus a surrender fee).
- Term insurance. Term life insurance provides a death benefit only. Policies are purchased for specified terms, such as a ten-year term. Premiums are fixed for the duration of the policy, but when it expires, renewing the policy gets more expensive over time.
Because part of the premium is invested to build value, whole life insurance is more expensive than term life, but premiums do not change. Many young families buy a less-expensive term life policy. When a term policy runs out, they obtain a whole-life policy to create an asset that is sure to increase in value over time.
There are several rules to keep in mind about life insurance beneficiaries in California:
- You can name anyone as a life insurance beneficiary. As the policy owner, you can usually change the beneficiary at will.
- Some life insurance policies appoint irrevocable beneficiaries, in which case the beneficiary cannot be changed once one has been designated.
- In a divorce, a life insurance policy purchased during the marriage with community funds is likely to be considered community property. This means an ex-spouse may be entitled to a portion of the payout, even if they are not named as a beneficiary.
- If a divorcing spouse has a whole life policy, the spouses may be required to divide the policy’s cash value. However, ownership of the policy will usually transfer to a spouse who is listed as the beneficiary. This means that the insured’s ex-spouse will become obligated to make premium payments and will have the right to change the beneficiary.
- If a life insurance policy was obtained as a benefit of employment, it is governed by ERISA, the Employee Retirement Income Security Act of 1974 (unless the employer was a government or a church). ERISA provides that the beneficiary named at the time of the policyholder’s death is always paid, regardless of the insured’s marital status and who is named as beneficiary.
It is important to revisit estate planning documents, such as wills, trusts, and life insurance beneficiaries, as changes in your life occur to make sure they continue to reflect your desires.
Contact Our CA Trust, Estate, and Probate Trial Lawyers
Estate planning is appropriate for everyone in California, regardless of their perceived wealth or the size of their estate. If there is a dispute about your inheritance or your rights as a trust beneficiary, reach out to the attorneys at Albertson & Davidson LLP for legal assistance in probate and estate litigation.
Our law firm has offices in San Francisco, San Diego, Carlsbad, Redwood City, Irvine, and Los Angeles. Contact us online or at (855) 928-0542 for a free initial consultation.
